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4. Covenants to provide information.
Restrictive covenants also require a
borrowing firm to provide information about its activities periodically in the
form of quarterly accounting and income reports, thereby making it easier for
the lender to monitor the firm and reduce moral hazard. This type of covenant
may also stipulate that the lender has the right to audit and inspect the firm’s
books at any time.
We now see why debt contracts are often complicated legal documents with
numerous restrictions on the borrower’s behavior (fact 8): Debt contracts require
complicated restrictive covenants to lower moral hazard.
Financial Intermediation
Although restrictive covenants help reduce the moral haz-
ard problem, they do not eliminate it completely. It is almost impossible to write
covenants that rule out every risky activity. Furthermore, borrowers may be clever
enough to find loopholes in restrictive covenants that make them ineffective.
Another problem with restrictive covenants is that they must be monitored and
enforced. A restrictive covenant is meaningless if the borrower can violate it know-
ing that the lender won’t check up or is unwilling to pay for legal recourse. Because
monitoring and enforcement of restrictive covenants are costly, the free-rider prob-
lem arises in the debt securities (bond) market just as it does in the stock market.
If you know that other bondholders are monitoring and enforcing the restrictive
covenants, you can free-ride on their monitoring and enforcement. But other bond-
holders can do the same thing, so the likely outcome is that not enough resources are
devoted to monitoring and enforcing the restrictive covenants. Moral hazard there-
fore continues to be a severe problem for marketable debt.
As we have seen before, financial intermediaries—particularly banks—have the
ability to avoid the free-rider problem as long as they make primarily private loans.
Private loans are not traded, so no one else can free-ride on the intermediary’s mon-
itoring and enforcement of the restrictive covenants. The intermediary making pri-
vate loans thus receives the benefits of monitoring and enforcement and will work
to shrink the moral hazard problem inherent in debt contracts. The concept of moral
Chapter 7 Why Do Financial Institutions Exist?
151
hazard has provided us with additional reasons why financial intermediaries play a
more important role in channeling funds from savers to borrowers than marketable
securities do, as described in facts 3 and 4.
Summary
The presence of asymmetric information in financial markets leads to adverse selec-
tion and moral hazard problems that interfere with the efficient functioning of those
markets. Tools to help solve these problems involve the private production and sale
of information, government regulation to increase information in financial markets,
the importance of collateral and net worth to debt contracts, and the use of moni-
toring and restrictive covenants. A key finding from our analysis is that the existence
of the free-rider problem for traded securities such as stocks and bonds indicates that
financial intermediaries—particularly banks—should play a greater role than secu-
rities markets in financing the activities of businesses. Economic analysis of the
consequences of adverse selection and moral hazard has helped explain the basic fea-
tures of our financial system and has provided solutions to the eight facts about our
financial structure outlined at the beginning of this chapter.
To help you keep track of all the tools that help solve asymmetric information
problems, Table 7.1 summarizes the asymmetric information problems and tools that
help solve them. In addition, it notes how these tools and asymmetric information
problems explain the eight facts of financial structure described at the beginning
of the chapter.
TA B L E 7 . 1
Asymmetric Information Problems and Tools to Solve Them
S U M M A R Y
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